Time to Read: 10 Minutes
The Biden administration has proposed various tax reforms impacting wealthy Americans. Specifics are sparce, and the proposals are often, perhaps intentionally, opaque. But, given that the President’s political party holds a slim majority in the Senate and could implement many of these changes on its own (through the reconciliation process), we need to do our best to anticipate the changes coming to our tax system.
The Biden Administration has proposed numerous increases to effective tax rates as well as the upending of certain long-standing aspects of the tax code that the administration has referred to as unfair.
Raising the Income Tax Rate
The President indicates that he would like to increase the ordinary income tax rate to 39.6% – up from its current, temporary rate of 37%. Today’s lower rate was enacted by the former President’s Tax Cut and Jobs Act. It is scheduled to revert back to the 39.6% at the end of 2025, but President Biden would like to increase the rate immediately.
Increasing the Capital Gains Rate
In the American Families Plan, the President has also proposed increasing the current capital gains rate of 20% to the top ordinary income tax rate for those households making more than $1 million per year.
This change is positioned by its proponents as impacting a very limited number of taxpayers due to the $1 million-per-year income hurdle. In fact, the administration notes that only .3% of American households make that amount annually on a regular basis.
But there are many more households that will have that amount of income in a single, important year due to a liquidation event they have been planning for, such as selling a closely held business, diversifying a large stock position, or liquidating a family real-estate investment. This increased tax rate would act as a significant surtax on these transactions.
Take, as an example, a retired executive of a publicly traded company holding $7MM worth of stock with a basis of $2MM and $500K of other annual income. If she decides to diversify her position, the executive will have $5MM worth of long-term capital gains. Under current law, the capital gains rate of 20% would result in a tax of $1MM. Under the proposed capital gains regime, an additional tax of $882,000 would be due. (The first $500K of capital gain is still taxed at 20% [$100K] and the additional $4.5MM is taxed at 39.6% [$1.782MM]. Only the first $500K gets the preferred 20% rate because that gain plus the other annual income equals $1MM.)
Of course, clients also worry that the income threshold for this new phase-out of capital gains could be made lower in the years to come.
Further, in an explanation provided by the Department of Treasury known as the “Green Book,” the Biden administration proposes this change be made retroactive to early in 2021. Many individuals, including a number of our clients, made investment decisions earlier in the year based on the law in place at the time. To change the rules of the deal after a business decision was made and executed may strike them as unfair.
Limiting Section 1031 Like-Kind Exchanges
Real estate investors have long had the ability to sell investment property and defer paying any capital gains so long as they reinvest all the proceeds in another parcel of investment real estate. This feature of the tax code is intended to create a more fluid real estate market, but it has also allowed many investors to defer millions in capital gains for decades. The Biden administration proposes to limit this deferral amount to $500,000 per year.
Critics of the change fear that this limitation would inhibit real estate investors from selling and could therefore add significant viscosity to the market.
Altering S Corporation Arrangements
Currently, employment taxes (such as the 3.8% Medicare Tax) apply only to the salaries paid to an S Corp owner and not to the distribution of corporate profits. The Biden administration proposes subjecting those corporate profits to the Medicare Tax as well. This would bring the treatment of S Corporations in line with the treatment of other pass-through entities such as partnerships and LLCs.
While this change would cause an immediate increase to the effective tax rate for S Corp owners, there may be a second tax shoe to drop.
Though not in the recent pronouncements, President Biden has indicated in the past that he wants to impose the 12.4% Social Security tax (another employment tax) on all earned income above $400,000. This would be the most significant tax increase on earned income included in any of the suggested changes. If the treatment of S Corporation distributions is changed for the Medicare Tax, the same change is almost certain to be applied to any future imposition of an expanded Social Security tax.
Taxing Family Transfers
One of the most transformative proposals from the Biden Administration is to begin treating gifts and estate bequests as taxable events. That is, the transfer of property to a family member (as a gift during life or upon death) would be treated as if the property were “sold” for full, fair market value – even though the “seller” received nothing.
Under the current structure, there is no tax impact of making a gift. And distributing property from an estate has no tax impact on either the estate or the beneficiary. (This is not to be confused with any estate tax that may be due based on the size of the estate itself.)
The recipient of gifted property has a basis in that property that is the same as the donor’s basis (known as “carry-over basis”). Property received from a decedent’s estate, on the other hand, is equal to the value of the property at the time of the decedent’s death (known as a “stepped-up basis”). This step-up in basis has the effect of wiping out significant capital gains that would have been due if the decedent sold the property before death.
The Biden administration would eliminate this “step-up” and impose a capital gains tax on any appreciated family property owned by the senior generation at the moment of death. This capital gains tax could be at the proposed 39.6% rate and would be owed by the estate itself. And, to be clear, this is a new taxable event – not the estate tax. The estate tax would still need to be calculated and paid by affluent families.
Other Potential 2021 Tax Reform
There are still many issues discussed on the campaign trail and informally that have not yet been included in White House or Treasury Department statements. These include, among others, increasing the Social Security tax obligation for those making more than $400K (mentioned above), limiting the beneficial impact of itemized/charitable deductions, and substantially increasing the effective gift and estate tax rate on families.
We are in the midst of the significant political turmoil that always surrounds major tax reform. Current bipartisan efforts may bear fruit resulting in compromise on some of these issues. Or these negotiations may falter making them a prelude to an entirely partisan tax reform.
We will follow the political process and likely see draft legislation in the coming months. But we are working with our clients now to make adjustments to their overall wealth plans. We want to ensure flexibility and, most importantly, not allow this turmoil to impact significant economic decisions or deter planning that it already in progress.
It is important for you to stay abreast of the significant changes that impact your financial picture and take action where necessary. Or you can work with an advisor who will bring you updates as changes occur and who will work closely with your tax and legal advisors to ensure your decisions are implemented.
If you have any questions about how these proposed changes may impact you and your family, please reach out to us.